Using COT to follow the smart money

The first step is to understand the nomenclature shown in “Big money flows” (below). Remember, we are looking for term-trend changes, and one of the best time frames for that is monthly price and COT charts.

A reliable indicator for this exercise is moving average convergence-divergence (MACD), applied here not to price but to the speculative money flow net positions from the CFTC’s COT reports at www.cftc.gov. The MACD simply is a way to use different duration moving averages to determine trend changes, identified by when the lines cross each other. The two different moving averages used for the MACD on “Big money flows” are the 12-month (blue line) and 24-month (red line) durations. When they cross to the downside, it is a money flow sell signal. When they cross to the upside, it is a money flow buy signal.

Let’s look at 2008 when crude oil made a historic high and review what this methodology would have predicted. As you can see, a major MACD money flow sell signal was triggered in May 2008. This sell signal occurred two months before the final top and before one of the greatest collapses in crude oil history. The COT/MACD analysis was an excellent leading indicator that a major top was approaching and that a significant selling opportunity had become available to investors and commercials alike.

While COT analysis is a reliable trade entry signal, it is not quite sensitive enough to protect profits. For that, it’s better to rely on an indicator based on price itself. There is a reliable trigger to cover a particular position and take profits after a major MACD money flow sell signal/buy signal has been initiated. Applied to price, it’s when the three-month moving average (red line) and the six-month moving average (blue line) cross.

Looking at the chart, we can see that a bullish crossing of these moving average lines occurred in April 2009, which would have directed us to buy back shorts at about $60 per barrel on a short position initiated around $120 per barrel, for a tidy $60 per barrel profit.

Other signals generated on this chart include:

A MACD money flow buy signal was triggered in June 2009 at $70 per barrel. Using the same moving average methodology for the spot price chart would have gotten us out of the market in July 2010 at about $75 per barrel for a small $5 per barrel profit.

A MACD money flow buy signal was triggered November 2010 at $85 per barrel. A spot price moving average sell signal was triggered at $95 per barrel for a modest $10 per barrel profit.

In September 2011, a MACD money flow sell signal was triggered at about $80 per barrel, which was followed by a surprise rally. The price indicator got us out of the market in December 2011 at $95 per barrel for a $15 loss.

About the Author

Shawn Hackett, commodity broker and author of the Hackett Money Flow Report newsletter (www.hackettadvisors.com), is a nationally recognized agricultural commodity expert with more than 18 years of money management experience.